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September 10th, 2007:
Speech given at the Foundations and Endowments Investment Summit

pdf version

How Modern Money Operates and the Consequent Investment Implications

by Cliff Viner, III Associates

I’m taking a great risk here today. I’m taking a great risk in presenting statements that may be exactly contrary to what you’ve been led to believe by the media, well known economists, and even by former Fed Governors and chairmen. I know this is a risk because my partner Warren Mosler, as well as myself and our firm, have been actively advancing these ideas for the past 15 years. We have been widely disregarded, with the exception of Cambridge in the UK, and the University of Missouri at Kansas City, being amongst the few notable successes where 40 PhD’s are now training in our program. I personally have been rebuffed at the University of Pennsylvania and the Wharton School, where I graduated undergrad in 1970 and the graduate division in 1972.

But I’m going to take this risk because it’s important to our economic futures, to recognize how things actually work, and because it has policy and investment implications for all of our business decisions. I’m taking the risk because I do not want all of you, who have taken your valuable time out to hear this talk, to have the experience of spending all this time, and not learn anything new of value.

Let’s start with some incredibly simple, but incredibly powerful concepts. All the major currencies in the world are no longer backed by anything. They are not commodity-based or commodity-backed currencies anymore. The only thing the Fed will give you for a 10 dollar bill is two fives. This is called fiat money and this is what we have.

So why do today’s currencies have any value? Simple question. We’re all veteran money managers and we should have the answer. You’ve probably heard answers like it’s the medium of exchange, or a storehouse of value, or the most widely given answer, faith in the currency, which was the only answer given to me when I asked the entire Economics faculty at a major University. So do you believe that the entire multi-trillion dollar world dollar economy is built on faith, as well as the yen and Turkish lire denominated economies?

The answer to why this fiat currency has value is actually on the money. It says “This note is legal tender for all debts, public and private”. The key word is public. The dollar is the only medium for extinguishing tax liabilities to the sovereign government. Money is tax driven, and that’s why it’s valuable.

That’s why we care about dollars, the Japanese care about yen, and why the Turks care about Turkish lire. When the Mexican peso blew up and all faith was gone, why did it only go from 3:1 (dollar) to about 10:1, instead of 100:1 or a million:1, or just vanish completely? When the ruble lost all faith, it only went from 6:1 to about 28:1, it didn’t go worthless or vanish. As long as there are enforceable taxes due, payable in a particular currency, it will have value.

This concept was perfectly understood centuries ago, but forgotten during the commodity money phase. The great Commonwealth of Virginia, established four centuries ago, knew this. They wanted to establish a currency to facilitate commerce. The government could issue currency, or spend in a new currency, but people would laugh and think why should I accept this piece of paper? The first thing Virginia did was establish a tax, let’s just say a 100 card tax per person per year. Now people would ask what they had to do to earn the currency, to be able to pay the tax, and not go to prison. The need for the cards makes the people willing sellers of goods, services, and their labor to get the cards, and avoid penalty for non payment. In this manner, the state can use its otherwise worthless paper to provision itself. The government established the amount of value of the currency, by what it demanded in exchange for these cards. The government is the monopoly issuer. Fiat currencies are tax driven.

Now that we’ve established our state, our tax, and our fiat currency made of these pieces of paper to pay taxes, let’s go further. Let’s say we’re going to be fiscally responsible in our new sovereign state. We’re going to run a budget surplus. We’re going to tax 100 cards, and we’re only going to spend 90.

What is going to happen? There are not enough cards to pay the tax. People will be offering their possessions and their labor for sale to try and get the cards to pay the tax, but sufficient cards are not in circulation to meet their needs. The result is called deflation; people scramble to sell anything to get cards that in the aggregate do not exist.

Okay, so you as Governor of Virginia notice this crisis going on, and you realize your mistake and say, I’ll tax 100 cards and I’ll spend 100 cards. I’ll run a balanced budget. Great. But let’s say I wanted to put one card in my savings account, or keep one around for spending money. I can’t. There are no cards left. The government has spent 100 cards and taxed 100 cards. There is nothing left for what I very carefully call net financial savings.

So let’s talk about savings, or maybe put another way, making money. How can we save money? We see the problem in old Virginia, no cards to save, but it’s the same exact notion for the U.S. dollar savings today. Let’s say that I represent all domestic dollar holders (individuals, pensions, ins cos, banks) and I have a total of one net dollar, meaning net of borrowing. Let’s say you represent all foreign net dollar holders (Toyota, central banks, any foreigners who have net dollars), and you have a total of one net dollar. So there is a total of two net dollars in the world. How are we as a group, going to save money? I guarantee you, that no matter what we do, at the end of the year we’ll all have two net dollars total. You may have $1.50, while I have $0.50, but we’re stuck, the total is two dollars. It’s the same problem as in old Virginia. So, how do we get net financial savings? The answer is, the only way to add to dollar net financial savings, is for the sovereign government to spend money, and not ask for it back in taxes. In other words, deficit spend.

Deficit spending is the source of worldwide net new U.S. dollar financial savings. The national income accounting identity is: the Government deficit EQUALS the non government accumulation of net financial assets.

Notice the word equals. Not approximately, but equals. So when you hear that the deficit is draining our savings, or they show you the National Debt Clock, it’s really the World Dollar Savings Clock. We’ll do more on deficits in a little bit.

Let’s get back to our new sovereign state. We notice that people want to save some cards each year. So as the wise Governor, we decide to tax 100 cards each year, but we will now spend 105 cards. Let’s say that people seem to want to save about 5 cards per year. So here is what’s interesting. We will be deficit spending 5 cards per year, but people want to save these cards, not spend them. Therefore, there is some noninflationary level of the deficit related to the desire to accumulate net financial assets. You can run a deficit without causing inflation if it matches savings desires.

Let’s talk about those 5 cards. At the end of every day, someone is going to have those cards. I could have lent them to you, and you could lend them to a corporation, or even to a bank. But at the end of the day, someone has the cards. How are they going to earn interest overnight? They can’t, not unless the sovereign says, if you give me those 5 cards, I’ll give you a different card, a promise card to pay back those 5 cards with interest. Looks like a Treasury bill to me.

But let’s think about it. Did the sovereign borrow the money to spend? Did the sovereign go begging to the markets for money to be able to spend? No, it’s actually the other way around. The sovereign spends first, and the market begs the sovereign for a security so it can earn interest.

In Fed speak, securities are offered to drain excess reserves, which are called offsetting operating factors. Sound familiar? This is the way all these fiat currency systems operate. The U.S. government does issue securities, but only to support an interest rate, not to borrow and spend. That’s why the “credit” is good. If that’s too much to believe, think of Turkey. Turkey’s annual lire deficit had been running over a quadrillion lire, inflation was 100% per year, triple digit interest rates, and there was huge currency depreciation. Not much faith there. How come they never defaulted? Either they are the greatest borrowers ever known to man, or it’s simply a reserve drain of extra cards.

Let’s continue with old Virginia and the cards. We just saw how the government can create Treasury bills, which are very much like money, and are really just time deposits at the Fed. So we have Treasury bills. But where do bank deposits come from? Again, the answer is from the very first week of any Money and Banking course, and yet very few people recognize the answer. The answer is that all deposits come from loans as a matter of system accounting. Loans create deposits. Most people believe you need funds, deposits, or savings to lend. Absolutely not true. The loan immediately creates its own deposit. That’s how the accounting of the banking system works. You start a bank with $10 in capital and are allowed to leverage to make about $150 of loans. The bank balance sheet includes $150 of loan assets and $150 of deposit liabilities. Loans create all bank deposits.

So now let’s bring in the Federal Reserve. I have very limited time here, so I’m just going to say that we hear about the Fed injecting reserves, pumping in money, printing money, pumping in liquidity to the banking system, and funds not getting distributed to the right people. This is utter misrepresentation and has no application to the non government sector. The Fed’s only tool is a price tool, the fed funds rate. It has no quantity tools.

The Fed has no direct control, over the quantity of bank deposits being created, or the quantity of any other form of credit. All this reserve management from the Fed, adding or subtracting reserves, is just the management of clearing checks at the bank’s segregated Fed accounts. The Fed acts when system or Treasury operating factors may make some of the pluses and not offset the minuses, or the unusual situation like recently, when banks might be afraid to trade their reserves with another bank in the fed funds market.

The Fed does not supply money the banks use for lending, does not directly affect the quantity of bank lending or what is casually known as money supply, and can’t reflate and pump money to banks or anyone else.

Note that when Barclay’s borrowed from the Bank of England 10 days ago, it was because of a clearing house settlement problem at the Central bank.

Please see me later so I can explain what the Fed did on 8/17. They lowered the discount rate only to control the funds rate better and to raise the funds rate from low levels where it was trading. I’ll show you the 8/16 email which shows exactly this recommendation which we communicated to the Fed.

When Japan pumped 30 trillion of excess reserves into the system, this did absolutely nothing, except insure that the overnight funds rate stayed at zero. All the BOJ did, was not offer any JGBs for sale or normal repo operations. People wanted JGBs. The MOF bill auctions were hundreds of times oversubscribed at a yield of 1bp! Go check it out. People wanted to earn something rather than nothing. People wanted their reserves drained. When the reserves were drained and quantitative easing ended, all the BOJ did was offer JGBs to the banks. The economists talked about how the transmission mechanism of this excess liquidity was not making it a real economy. It can’t. Bank lending to the private sector is never reserve constrained. Bank reserves are inside money at accounts at the Fed, and have nothing to do with lending to the non government sector. Remember, lending creates its own deposits. You don’t need reserves or funds.

Let’s talk about money a little more. Everyone talks about money, money supply, and M1, M2, M3. What are these measures? They are basically deposits in the banking system. So we watch the aggregates grow, creating more money. But is it the stuff of the quantity theory of money? If money is doubled, prices are doubled. Remember, all deposits come from loans. All the money supply is not net money, or the net financial assets I talked about at the beginning, its gross money. You get borrowed money in your account, no net money. People are long or short.

So where else do we see this exact relation of longs and shorts? All this gross money is really like the open interest on the Merc. There’s a long (the guy with the money) and a short (the guy who borrowed the money and spent it). When we analyze wheat prices, yes, we do look at open interest. But we look much more closely at current net stocks of wheat, and whether there will be a good new crop. So let’s think about that. We’d like to know about the current stock of net money. But, we said earlier this stock of net money comes from past deficit spending and becomes Treasury securities, and we’d like to know about the new crop. The new crop of net money comes from new deficits. A budget surplus is not only no new crops at all; it’s burning up some of the stocks in the silos. Take a look at the past dollar fx squeezes during budget surpluses.

If you have huge open interest, or huge open interest growth, in this case, huge growth of bank deposits, that circumstance is probably much more sustainable when the net money is growing to support it. The private sector may be able to sustain large borrowing and spending for extended periods. Without the net money growing beneath it, by definition the system leverage gets higher and the potential debt service burdens get progressively more difficult. This has profound implications for how to look at money, credit expansion, and business cycle phases, overextension and contraction.

So now let’s look at this notion of net money and business activity. The entire World Net Dollar Balance is just the opposite of the U.S. Government Dollar Balance. That’s what we just said about deficits providing net dollar savings. This is accounting, not theory. This is not in dispute.

But, if we’re just talking about the U.S. Domestic sector’s net dollar balance, that equals the opposite of the U.S. Government balance plus or minus the foreign account balance.

So a U.S. Government deficit and a U.S. trade surplus would both add to U.S. Domestic savings. Again, this is not in dispute. It’s an accounting identity, not theory. But so many major economists forget about this basic equation and what it means. What does it mean?

Let’s look at the chart. The first conclusion is to notice that if the U.S. foreign account balance is a bigger negative than the savings we get from U.S. government deficit spending, then the U.S. must reduce its net financials assets (generally borrowing) to finance our current consumption. This again, is an accounting identity.

This next chart shows the course of what’s happened. Look at the recent increases in the financial obligations burden to keep our consumption and aggregate demand growing. The U.S. budget deficit is too small to provide enough net financial savings to U.S. domestics to offset our foreign trade balance. This can persist for awhile, but it is ultimately not a sustainable process.

Let’s talk more about savings. The generally accepted notion is that we have to boost savings to be able to boost investment. Good for the economy. Let’s create more savings plans. Remember, saving is not spending your income. If my wife, inexplicably, decides not to spend our income, and not to buy any more cars, is GM or is Toyota going to invest in a new plant? No way. The paradox of savings has been known for centuries, but forgotten. As a matter of fact, the act of saving will reduce effective demand, not stimulate investment, leave inventory unsold (you produced but didn’t buy all the output) and will most likely reduce employment and income.

So what does happen? Savings does equal investment, but it doesn’t happen that you need savings to make the investment.

It is the act of investment that creates both real and financial savings. Savings are the accounting record of an investment having been made. By definition, investment is spending money to produce a capital good that is not able to be currently bought or consumed. There is nothing to buy, so you must save. The workers have the money they were paid, and their only choice is to save and invest, directly or indirectly, in the capital good. You can individually try to save, but as a whole we can not determine to save. The level of investments will determine the level of saving.

Let’s talk about U.S. saving. You at this conference are the driving force in the powerful structure of incentives to save in the U.S. A large portion of personal income is encouraged to go, and does go, to IRAs, Keoghs, life insurance reserves, pension fund income, endowment income, and other money that compounds continuously and is not spent. Even much of what foreigners get, such as foreign Central Bank dollar accumulation is not spent. We call all this savings demand leakage. This U.S. structure of tax advantaged savings has probably caused the U.S. private sector to desire to be a net saver.

There are two important things about this situation. We do not need these savings for investment. So there’s no need to promote all these plans and incentives. Sorry guys. As we previously pointed out, this desire to not spend will reduce aggregate demand and result in unsold output, causing declining economic activity and declining prices. So what has happened? All these savings plans have allowed the government to deficit spend, to offset all this structurally reduced aggregate demand, without causing inflation. Once we recognize that savings does not cause investment, it follows that the solution to unemployment or low capacity utilization, is not to encourage more savings.

Let’s continue to talk about foreign balance. If we’re running a trade deficit, foreigners are sending us goods and we are sending them dollars. We’re buying their stuff instead of domestic stuff. For that amount of demand, our employment and output is being reduced. So we get underemployment in the U.S. unless we manage to keep domestic demand sufficiently high as we have been doing. When we do that, the notion of comparative advantage is at work and we have a net gain. We’ve been benefiting from this process and should not be fighting imports.

Now remember our identity of the domestic balance is the government plus foreign balances. If we have a 5% foreign trade deficit, but the government is giving us savings with a 5% budget deficit, we’re still only at zero net financial savings. The implication is that now the government can spend a 5% deficit to fully employ our resources without inflation. The government could deficit spend even more to satisfy the desire for positive net financial savings.

Let’s explore this trade deficit for a little bit. There’ so much talk of how vulnerable we are because foreigners won’t keep financing our foreign trade deficit. There is no such thing as foreigners financing the trade deficit.

I go to Citibank and I borrow money. My account is credited with 50K in deposits and Citi has an asset of 50K in loans. I take my deposit, buy a car. The foreign seller of the car has the money, first as a deposit at a U.S. bank. Everyone is happy, no imbalances and there is no borrowing of foreign capital. Citibank financed the borrowing for my purchase. The foreigner has dollar savings. Domestic credit creation funds this entire foreign savings, all $700 billion. There is no imported capital to fund the trade gap.

Let’s examine this trade deficit further. The U.S. government is begging China to revalue their currency upwards. Are we nuts? Why do we want to pay more for Chinese goods? Why do we want to give the Chinese a pay raise? We don’t allow our own workers minimum wage raises, and yet we want to give those raises to the Chinese.

They’re selling their goods below fair value which is dumping, and what we know to be an unfair trade. Let’s examine that. Dumping is a political problem, not an economic problem. Let’s put aside the issues of whether they’re incurring pollution costs or other social costs, counterfeiting, patent infringement and the like. Let’s say the Chinese are dumping, selling us goods at 35% of fair value. Here in the U.S. we complain. But what is selling us goods at 35% of fair value? It’s selling us 35 goods at fair value and 65 goods for nothing. There is no way, in the aggregate, that we can be worse off when they take their resources, capital, labor, technology and education and sell us goods for nothing. We are better off. The problem, as I said, is a political problem. Because they sell us goods for nothing, there are workers in the U.S. without incomes. But as we showed before, the U.S. government can now deficit spend so we can get the Chinese goods for nothing, and employ or reemploy these workers in the same, or different areas of the economy, to reestablish employment and aggregate demand without causing inflation.

Just two more comments on the foreign trade balance. We are so worried. We’re worried that they own all these paper assets and might sell them. But let’s think of who is at risk. We have the goods and they have these pieces of paper. They have no idea what those pieces of paper are going to be worth in the future. If they dump dollar assets, the value of their remaining holdings is going to fall dramatically. Who’s at risk? We have the cars, clothes and golf clubs. They have the indeterminate value of the paper.

The conventional wisdom is we want the Chinese and the Japanese to start spending on consumer goods, solve the unsustainable world trade imbalances. I don’t. Who wants to be competing for goods with 1.4 billion Chinese? What will happen to the price of all the items we’re consuming once there is competition for those goods? Nope, I want them to work 16 hours a day, sell us everything we need for nothing, have them never buy anything from anyone, and we play golf all day. The conceptual summation of all this is that exports are a cost and imports a benefit. Think about it.

So let’s conclude with some thoughts about the U.S. economic outlook. My partner Warren Mosler, who focuses on economic analysis and has an exceptional command of these dynamics, has helped offer some of these thoughts about the situation.

The U.S. budget deficit continues to contract. As our little identity equation showed before, the result is that net financial assets are not being added fast enough to support the gross dollars and credit structure, to help both support aggregate demand, and to satisfy the desire for savings engendered by all the incentive savings plans represented by this audience. It calls for budget balancing only making all of this worse.

As such, the financial obligations ratio rises to where the U.S. consumer can no longer continue borrowing at previous growth rates. Allocations to passive commodities by pension and endowment institutions actually exacerbated aggregate demand in the past two years. You are all supposed to buy stocks or bonds, but wound up buying all sorts of commodities. Now this phenomenon is cresting, and should also slow aggregate demand. Exports should be a help as they are picking up, but will probably not accelerate sufficiently to maintain fast GDP growth.

On the inflation front, we still see inflation as a problem despite U.S. economic weakness. It is our view that the Saudis basically set the price of oil and let quantity vary. They are the swing producer. They are comfortable with oil in this price range, so we do not expect price declines. Cost push of these prices is still occurring throughout the U.S. and world economy. Agricultural commodities are now linked to energy sector prices through the biofuels industry and are causing a second wave of food inflation. The Fed is very concerned about inflation, and that’s overall inflation, not just core inflation. If we have 0.2 month to month CPI increases for the balance of the year, YOY headline inflation will be well above 4%. The Fed is adamant about the importance of expectations, and those types of CPI numbers will worry the Fed about losing the 25 years of inflation progress they’ve made. With the labor market still tight, low levels of unemployment and high levels of capacity and resource utilization, the Fed is actually hoping for growth to slow substantially to contain this inflation. It may take much more slowing than that or a significant fall in energy and gasoline prices, for the Fed to ease.

With regard to the all important credit structure, I believe there is a very significant shift underway. In the recent past, lending (gross money) has been made easily available for all sorts of lending, business plans, assets and other leveraged ventures. These gross dollars have fueled both current cyclical economic activity and the rise in dollar asset prices around the world. I believe this is changing through both a repricing of the cost of assuming lending risk, and in a change of the simple willingness to lend or the availability of credit. Remember, loans create all deposits. No loans, no deposit growth. The Fed may be willing to oversee this significant contraction. Why? All of us, and the Fed, watched all these non-regulated lending or investment entities with much higher risk parameters go out and snub their noses at regulated entities and seemingly pass them by in good times. The Fed is not likely to want to provide a safety net and reward them for this type of frowned upon behavior. The Fed will probably be happy to see assets come back to the banking system, under their rules, regulations, and purview. In addition, the Fed will be happy for the greater stability it will bring to the capital structure of the markets and economy because the funding on bank’s balance sheets is anchored by FDIC insured deposits that don’t flee. The U.S. learned this lesson in 1934 with the establishment of deposit insurance to prevent runs on bank funding. The current voluntary termination of lending agreements (loans roll off), or withdrawal of CP deposits, and even withdrawals from hedge funds, highlight the system fragility of highly leveraged enterprises that are subject to liquidity redemptions. The sectors of the market and economy that relied upon these lending and securitization structures for funding will likely suffer, and the lending or credit participants in these sectors will likely be replaced by banks and GSEs.

Fiat currency sovereign issuers are not at risk. However, corporations, municipalities, leveraged loan and investment structures (LBO, private equity), and foreign countries issuing in denominations other than their fiat currency are at risk.

I’ll even present the notion that European government debt is at risk because a strict reading of Maastricht has created municipalities, not sovereigns, without the ECB to provide support. Did you notice that Saachsen Bank had to be bailed out by the German Savings Bank Society?

However, I have one note of caution or caveat to this notion of contraction and rationality. The financial engineering genie is out of the bottle. Financial engineering really began to accelerate when I entered the bond side of the business in the late 1970s with the advent of GNMA futures, Treasury bond and bill futures, currency and stock futures, and then the monumental creation of the interest rate swap, that became the foundation for modern derivatives such as caps, floors, swaptions, total return swaps, all variety of structured notes and even the recent explosion of credit derivatives. These instruments provide the ability to create huge notional exposures, with notional exposures in this credit arena that are hundreds of times the risk in the real economy. IBM used to have 1BB of bonds outstanding. That was the credit risk. Now the credit risk exposure taken by participants can be hundreds or thousands of times the size of the bond issue itself. While the risk may be more diversified or less concentrated, the huge notional size causes great market dislocations. But what I’m saying, is that in cycle after cycle, because it’s so difficult to make real spreads make real returns or real alpha, investors will again seek out the new product, the new leverage, the new derivative (like CDOs, CLOs, CDS) that allow the investor to greatly leverage to seemingly earn superior returns, only to see the eventual risks come to roost and the underlying risks exposed. It will happen again, the form will be different, but it will happen again.

I want to thank everyone for their great courtesy in attending today, and I hope this time together has accomplished something towards my goal, that you won’t be looking at the world economic scene in quite the same way again, and that maybe with a new understanding you’ll be an instrument for positive change in how we should conduct our economic lives.

Thank you very much.

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Article snip:

ECB Leaves Interest Rates at Seven-Year High to Fight Inflation (Bloomberg) - The ECBkept interest rates at a seven-year high to fight inflation even as evidence of an economic slump mounts. ECB policy makers meeting in Frankfurt left the benchmark lending rate at 4.25 %, as predicted by all 60 economists in a Bloomberg News survey. The bank, which raised rates last month, will wait until the second quarter of next year to cut borrowing costs, a separate survey shows. The ECB is concerned that the fastest inflation in 16 years will help unions push through demands for higher wages and prompt companies to lift prices. At the same time, record energy costs and the stronger euro are strangling growth. Economic confidence dropped the most since the Sept. 11 terrorist attacks in July and Europe’s manufacturing and service industries contracted for a second month. ECB President Jean-Claude Trichet will hold a press conference 2:30 p.m. to explain today’s decision.

Same as UK, less costly to address inflation now rather than support growth and address inflation later if it gets worse.

It’s been said in the US that the Fed needs to firm up the economy first, and then address inflation. To most Central Bankers this makes no sense, as they use weakness to bring inflation down.

In their view that means the Fed wants to get the economy strong enough to then weaken it.

The Fed majority sees it differently.

They agree with the above.

However, for the last year they have been forecasting lower inflation and lower growth were willing to take the chance that supporting growth would not result in higher inflation.

Now, a year later, the FOMC is faced with higher inflation and more growth than the UK and Eurozone, and systemic ‘market functioning’ risk remains.

The FOMC continues to give the latter priority as they struggle with fundamental liquidity issues that stem from a continuing lack of understanding of monetary operations.

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The mainstream view remains the cost of a near term recession in order to bring prices under control now is far less than the cost of a recession later if you support growth now and let prices continue higher.

Bank of England holds interest rate at 5%

by Gary Duncan, Grainne Gilmore

The Bank of England rebuffed mounting concerns over the rapidly weakening economy today and held interest rates at 5 per cent as it pursued its drive to quell soaring inflation.

The tough verdict from the Bank’s rate-setting Monetary Policy Committee (MPC) brushed aside pleas from business leaders and trade unions for a cut in base rates to shore up Britain’s growth, amid growing fears that the country is on the brink of recession.

The Bank’s decision came after headline consumer price inflation leapt to a 10-year high of 3.8 per cent in June, well above the Bank’s 2 per cent target, and amid expectations that it could hit 5 per cent over the summer, following swingeing increases in household gas and electricity bills imposed by utility companies.

The MPC had been widely expected to spurn pressure for a rate cut today in a bid to make clear its determination to bring inflation back to the target set by the Chancellor. The committee will almost certainly have discussed raising rates this morning, as it did last month, when Professor Tim Besley, voted for an immediate increase. He is expected to have done so again today, and may have been joined by other hawkish MPC members.

The Bank will set out its thinking more clearly next week when it publishes its latest forecasts for the economy in its quarterly Inflation Report. That is expected to emphasise the dilemma that the MPC confronts, with inflation set to soar far above target in the next few months, even as the economy slides towards a severe downturn.

The quandary facing the Bank was underlined yesterday as the International Monetary Fund sharply cut its forecasts for Britain’s growth this year and next, while issuing a warning that it saw “little scope” for interest rates to fall, although it also saw no need for an immediate rate rise.

Today’s no-change verdict by the MPC came despite bleak economic news in recent days, which have produced danger signs of recession.

Concern that Britain’s growth had ground to a virtual halt last month, and could even be in the grip of recession, were inflamed this week after bleak figures revealed growing frailty in the most critical parts of the economy.

These included shrinking activity in the services sector, the economy’s engine room that account for three quarters of the UK’s output, as well as in manufacturing.

The services sector, spanning businesses from cafes and leisure centres to accountancy and law firms, shrank for a third month in succession last month, according to the latest purchasing managers’ survey, regarded by the Bank as a key gauge of economic conditions.

Although services activity edged up from a seven-year low that was plumbed in June, the survey pointed to an even sharper slowdown ahead, with levels of outstanding business for the sector’s companies falling for a tenth month in a row, and inflows of new business dropping to a record low.

At the same time, it emerged that manufacturing is suffering its first sustained run of decline since 2001, after its output fell in June for a fourth month in a row, dropping by 0.5 per cent.

The figures were among the latest data confirming the dire plight of the economy, and came after official confirmation that the pace of Britain’s overall growth slowed to just 0.2 per cent in the second quarter, its weakest rate of expansion for three years.

The falling housing market remains a key source of economic anxiety, with the Nationwide Building Society reporting that house prices tumbled by a further 1.7 per cent last month, leaving them down 8.1 per cent on last year - their sharpest annual pace of decline since 1991.

The high street is also being badly hit by the downturn, with official figures showing that retail sales plunged by 3.9 per cent in June - their biggest monthly drop for 22 years.

Yesterday, the International Monetary Fund added to the mood of pessimism as it cut its forecast for Britain’s growth this year and next to only 1.4 per cent, and 1.1 per cent, respectively. The prediction of the UK’s worst performance since the end of the last recession raised the spectre of two years of economic misery.

In May, Mervyn King, Governor of the Bank, was forced to write an explanatory letter to the Chancellor, required by law, explaining why inflation had risen more than 1 point above its 2 per cent target, after it climbed to its then-high of 3.3 per cent. Mr King has admitted that he expects to write more such letters this year.

The Bank’s inflation headache has been further aggravated by signs of further severe price pressures in the pipeline to the consumer, Manufacturers’ costs rose at a record 30 per cent annual rate in June, and prices for goods leaving factories rose by a record 10 per cent. Inflation is being stoked by a sharp slide in the pound, by about 12 per cent over the past year, which lifts Britain’s bills for imported products.

However, there has been some let up in international food and energy costs, with oil prices tumbling by 13 per cent in a month, and prices for food products are also on the slide.

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(an email exchange)

>   
>   
>   On Wed, Aug 6, 2008 at 12:25 AM, Prof. P. Arestis wrote:
>   
>   Dear Warren,
>   
>   Just received the piece below. The situation over here is getting
>   worse but pretty much as expected.
>   
>   Recession signalled by key indicators of British economy
>   
>   
>   Best wishes, Philip
>   

Dear Philip,

Yes, seems tight fiscal has finally taken its toll and is now reversing the ugly way - falling revenues and rising transfer payments.

Without support from government deficit spending, consumer debt increases sufficient to support modest growth are unsustainable.

And with a foreign monopolist setting crude oil prices ‘inflation’ will persist until there is a large enough supply response,

It’s the BoE’s choice which to respond to, though ironically changing interest rates is for the most part ceremonial.

All the best,
Warren

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Treasuries Fall as Fed’s Plosser Calls for Interest-Rate Boost. Treasuries fell as Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank should raise interest rates “sooner rather than later.”

Fisher, Stern, and now Plosser as the palace revolt gains momentum into the August 5 FOMC meeting.

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Karim writes:

• CATERPILLAR SEES ECB CUTTING RATES AT LEAST 25BP BEFORE YR END
• CATERPILLAR SEES NO SIGN OF RECOVERY IN NORTH AMERICAN HOUSING
• CATERPILLAR ASSUMES AT LEAST ONE MORE RATE CUT LATER THIS YR
• CATERPILLAR SEES ‘DIFFICULT’ FOR ECONOMY TO AVOID A RECESSION
• CATERPILLAR SEES OIL PRICE AVG ABOUT 16% HIGHER IN LAST HALF
• CATERPILLAR SAYS 2Q SALES/REVENUE UP 30% OUTSIDE NORTH AMERICA
• Caterpillar Net Rises 34% as Asia, Mideast Building Lift Sales
• Caterpillar Reports All-Time Record Quarter Driven by Strong Growth Outside North America

Right, weak domestic demand for sure. But note the last few lines that represent the booming exports even though domestic economies around the world are slowing.

That’s what happens when they spend their accumulated hoard of USD here and spend less at home as they try to get rid of their USD hoards. This doesn’t stop until their holdings of USD fall to desired levels.

I still see continued domestic weakness with GDP muddling through due to exports and government spending.

And ever higher prices pouring in through the import/export channel.


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Weakness and inflation= rate hikes in the eurozone.

Fed response to same conditions later today.

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As mainstream economists, the Fed knows it took a very large risk when it cut aggressively, hoping its forecasts for ‘moderating inflation’ would play out, and knowing the following would happen if ‘inflation’ accelerated.

Bernanke May Regret Interest-Rate Cuts, Lawson Says

by Kim-Mai Cutler

(Bloomberg) Former U.K. Chancellor of the Exchequer Nigel Lawson said Federal Reserve Chairman Ben S. Bernanke may be “regretting” the fastest pace of U.S. interest-rate cuts since 1984 as global inflation accelerates.

The Fed reduced its benchmark rate by 3.25 percentage points to 2 percent between September and April 30 to stave off a recession following the collapse of the U.S. subprime-mortgage market. The Bank of England, also facing a slowdown, cut its key rate by 0.75 percentage point to 5 percent. The European Central Bank left rates unchanged at 4 percent for a year and signaled this month it may raise them in July.

“The Bank of England has been very cautious and careful and it has been much closer to the views of the European Central Bank,” Lawson, 76, who was finance minister from 1983 to 1989 under former Prime Minister Margaret Thatcher, said in a telephone interview. “It has not gone conspicuously the way of the Fed, where I suspect that Mr. Bernanke’s now regretting it.”

U.S. consumer prices rose 0.6 percent in May, the most since November, the Labor Department said June 13. Inflation in the euro area accelerated last month to a 3.7 percent annual rate, the fastest since June 1992, the European Union reported June 16.

Inflation caused by rising commodity prices is the biggest threat to the world economy, eclipsing concern about the seizure in the credit markets, finance ministers from the Group of Eight nations said June 14. The World Bank said on June 10 that global economic growth will probably slow to 2.7 percent this year from 3.7 percent in 2007.

Oil ‘Bubble’
Rising food prices and a “speculative bubble” in oil markets will prompt central banks to lift rates, leading to a “growth recession” where the rate of expansion is lower than historical trends, Lawson said in the interview.

Crude oil rose 95 percent from a year ago and traded at an all-time high of $139.89 a barrel in New York June 16. Corn for December delivery also traded at a record $7.915 in Chicago.

“Most of the central banks are very, very clear on just how dangerous it is to let inflationary expectations get out of hand,” he said.

Traders see a 48 percent chance the Fed will raise its target rate for overnight bank loans from 2 percent as early as August, up from 4.1 percent odds a month ago, futures contracts on the Chicago Board of Trade show. The chances of an increase in October are 99 percent, the contracts show.

Michelle Smith, a Fed spokeswoman in Washington, declined to comment on Lawson’s remarks.

‘Shallow’ Recession
The slowdown in the U.K. is going to last “longer than most people expect,” while remaining “shallow,” Lawson said. The economy, the second-largest in Europe, grew 0.4 percent in the first quarter, its weakest pace since 2005, as higher credit costs hurt construction and business services slowed, according to the Office for National Statistics.

“This is the hangover after the binge,” Lawson said. “It’s going to be very, very difficult for the next two to three years for the global economy.”

The U.K. won’t adopt the euro in place of the pound as a global slowdown heightens tensions between members of the 27- nation European Union, Lawson said. Ireland vetoed the bloc’s new government treaty June 13, sinking an agreement that needed ratification by all EU countries.

“There are going to be considerable strains within the euro area,” Lawson said. “There are going to be a number of countries that found the single currency satisfactory during the benign period, that are now going to hurt much more under these difficult conditions.”

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Karim writes:

FRB-5 stories since Sunday trying to dampen rate hike expectations seems like a coordinated plant: Page 1 of WSJ today, FT article today citing ’senior officials’, Market News piece from Beckner from yesterday, Washington Post article yesterday from Novak, and Blinder editorial in New York times on Sunday. Also Lacker was unusually tame yesterday in his remarks on inflation expectations.

Yes, agreed.

In fact, it can be said that this entire cycle has witnessed subdued inflation responses from top CBs. There is probably no precedent for the Fed cutting aggressively into the food/fuel negative supply shocks.

‘SOME’ have suggested this is a baby boomer phenomena - short sighted aversion to ‘pain’ by a bunch of spoiled kids more than willing to eat their seed corn seems to crop up everywhere. Nothing gets addressed until it gets bad enough to be a major crisis. Energy, biofuels, environment, Iran, weak levies, etc. etc. and now inflation.

It does seem to explain a lot.

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The FOMC can’t possibly believe that a 2% Fed Funds rate is the ‘right’ rate given current CPI of about 4%, core at about 2.5%, GPD moving back up towards 2%, unemployment ‘only’ about 5%, and inflation expectations showing signs of elevating.

The 2% Fed Funds rate is only appropriate if their forecasts show as sufficiently high probability of economic deterioration and increased ’slack’.

As Fisher and other have put it, they all believe low and stable inflation is a necessary condition for optimal growth and employment.

The Lehman issue will pass with a lot less drama than the Bear Stearns issue.

Q2 GDP forecasts are being revised up as most numbers are coming in better than expected.

Inflation continues to move higher.

The ‘Mike Masters sell-off’ in commodities will run its course, with commodities subject to competitive markets underperforming, and crude moving higher (when the smoke clears - they try not to make their position too obvious as with the Goldman sell off of August 2006) as Saudis continue as price setter.

2006 Crude Sell Off

I expect the sell off to be less than the approximate three month sell off from the Goldman index change in 2006.

Obama is looking strong, but it has been historically problematic to propose tax hikes and win the election.

“Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve,” Bernanke said in a speech to graduating students at Harvard University.

Yes. To the point. They are concerned their own actions might indicate a higher tolerance for inflation and thereby elevate inflation expectations.

“We will need to monitor that situation closely,” he said, but added there was little sign a “1970s-style wage-price spiral, in which wages and prices chased each other ever upward,” might be starting.

The 1970s were all about oil prices working through the cost side of the economy, just as they are today. And there are still many nations with weak domestic demand, weak currencies, and continuously high levels of inflation.

He said the impact of soaring oil prices has been “relatively muted” because the amount of energy used to produce a given amount of output — a gauge known as energy intensity — has fallen markedly since the 1970s.

This only extends the delay between food/energy prices and core CPI.

He also said policy-makers learned a lesson in the 1970s, in particular that they must keep long-term inflation expectations anchored to achieve low and stable inflation.

Yes, the FOMC and the mainstream truly believes this. In fact, it’s all they have regarding ‘inflation’ vs. relative value changes in their models.

“If people expect an increase in inflation to be temporary and do not build it into their long-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly,” he said.

Again, they all do truly believe this. They see inflation as a ‘monetary phenomena’, where somehow ‘too much money chases too few goods’. That makes ‘inflation’ a demand-side issue. Price pressures on the supply-side are only ‘relative value stories’ until ‘inflation expectations’ shape ‘long-term plans for setting wages and prices’.

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(An email exchange)

On Wed, Jun 4, 2008 at 12:57 AM, Eric wrote:
>     I guess you have seen this article.
>
>      Primes going down too.
>
>
>      More generally look at the attached graphs, they suggest that IOs and other
>      exotic mortgage are clearly a major cause of the problems, independently of
>      the quality of the loans. I think there is here a pretty good argument to make
>      that non-fixed mortgages, and more especially exotic mortgage have structural
>      characteristics that make them prone to speculative and ponzi structure. The
>      borrowers expect to be able to refinance at one point once interest rate reset or
>      the principal become due. Warren you were saying that proof of ability to pay
>     “libor plus 3 or whatever” was necessary to qualify. This margin of safety
>      (expected ability to pay libor +3 even though now borrower pay only teaser rate)
>      may have been destroyed in several ways.
>
>      - the interest rate may have reset at a higher rate than libor + 3, so that people
>      cannot afford the mortgage anymore.
>
>      - ARMs reinforce the probability of the previous effect, especially when libor when
>      up sky high after the crisis
>
>     - Income of borrowers felt short of expectations, expecially with the economic
>     slowdown (here fiscal policy is clearly a big player)
>
>     - The margin of safety thinned. Maybe previously they had to prove libor + 5 but
>     progressively borrower only had to prove libor + 4 then libor + 3. This would qualify
>      more borrowers and make the deal more sensitive to shock in product and financial
>      markets
>
>      In all this case the affordability of the mortgage is questioned Þ need to refinance Þ
>      if not available then sell the house (short sale or foreclosure). Fixed-rate mortgage
>      eliminate three of the previous reason (only income expectations is a problem).
>
>      Éric

agreed with all.

add to that food and energy prices taking income from home mtg payments, which could be the larger short term effect.

the fed has been taking some heat for this under the theory that the low rates have hurt the $ and thereby hurt the financial sector via the above channel, rather than helped the financial sector via lower rates ‘easing’ conditions via the lower payments channel.

the fed has argued this isn’t the case, insisting the lower rates have helped more than hurt.

also, the fiscal package could soften some of the delinquency increases for a few months.

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I like this not so much for his suggestion as for his assessment of the Fed.

This both expresses the market view of the Fed and the Fed’s own expressed concern that their previous actions could contribute to elevated inflation expectations.

“I think they should put interest rates up and worry about inflation. What do I think they’ll do? I think they’ll delay,” says Allan Meltzer, a professor of political economy at Carnegie Mellon and noted Fed watcher. “The Fed is spineless in response to pressures from Congress and pressures from Wall Street.”

In contrast, my best guess is the Fed is ready to act quickly to restore a ‘real rate’ ASAP as ‘market functioning’ risk subsides, no matter how weak the economy my get.

IMHO, it was blind fear of 1907/1930/gold standard deflationary tail risk that caused the Fed to cut rates into a triple negative supply shock, not a lack of resolve vs. inflation that pushed their ‘balance of risks’ towards ‘emergency’ cuts with much talk of being ‘nimble’ regarding ‘taking them back’.

The immediate deflation risk was seen to be coming from the housing collapse.

While housing remains weak, it is no longer perceived to pose the same broad-based deflationary risk. Instead, it is showing signs of leveling off, and with GDP and personal income muddling through, housing looks to be muddling through at current levels as well.

NOTE: In August, the Fed didn’t cut because inflation was deemed too high, and it’s a lot higher now.

I don’t expect ‘ordinary’ recession risks to keep them from moving to put a brake on what they see as elevating inflation expectations.

Even Yellen the Dove is ready to hike. They all believe low inflation is a necessary condition for optimal long-term growth and employment, and inflation is now by far the greatest risk to long-term growth and employment.

And they all agree the cost of slow growth now to reign in inflation is far less then the cost of bringing down inflation later should it continue to get worse. In the ‘balance of risks’, inflation is a risk because it is perceived as a crucial risk to long-term growth.

They also agree that their dual mandate is, therefore, met by keeping inflation low, which automatically optimizes long-term growth and employment.

The remaining dove position is that inflation isn’t a problem, as evidenced by low core reports and well-anchored wage demands, and that the current output gap is sufficient to keep inflation expectations from elevating and bring inflation down to desired levels over the next few years.

That position is quickly losing support as evidenced by two actual dissenting votes and a growing movement to the hawk side as perceived deflationary tail risk subsides, inflation expectations show signs of elevating and food/crude/import prices remain firm as they are further supported by the fiscal package.

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Recent comment by Fed Vice Chair Donald Kohn:

If longer-term inflation expectations were to become unmoored–whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought–then I believe that we would be facing a more serious situation.

This could be telling. It hasn’t been said before by any FOMC member, and it was voluntary, in that no one asked the question.

It is something he is trying to communicate.

The FOMC sees inflation expectations showing signs of elevating, and is wondering whether it is at least partially responsible.

Their ‘theory’ had told them there was an inflation price to pay for cutting into a triple negative supply shock if it went so far as to allow inflation expectations to accelerate.

Credit spreads are in substantially from the wides, GDP isn’t collapsing and forecasts are for modest improvements.

Fiscal rebates are kicking in, being spent, and supporting prices.

Inflation is ripping, and now has the full attention of the FOMC.

Oil 130+

Dollar down

Stocks down a touch

Interest rates up a touch

My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations.

The FOMC has never wavered on this all important aspect of monetary policy - they firmly believe inflation expectations are what causes a relative value story to turn into an inflation story.

In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored–whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought–then I believe that we would be facing a more serious situation.

If inflation expectations come unmoored for any reason, inflation is thought to follow.

And here he expresses concern that inflation expectations may be rising due to a public perception that the Fed easings mean the Fed has a greater inflation tolerance.

Governor Kohn is clearly concerned that the Fed’s actions since August may be causing inflation expectations to elevate, and his statement further implies that it will take actual ‘action’ on the part of the Fed to dispel the notion that they are more tolerant of inflation.

Markets will not believe the Fed will take action on inflation until after they actually do it, but that the Fed will respond to weakness regardless of inflation. This was expressed by today’s price action. With crude hitting $129 EDs a year out are 8 bps lower in yield.

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Hi Warren,

Do you think there is any chance that the Fed ever puts us into a steeply inverted curve, say something like 10% short rates with 6% long rates? Hard to imagine that happening with the housing market weak, but what do you think?

Very high probability - I’d say 85% chance if, as I expect, crude stays here or goes higher. maybe a lot higher.

Hiking causes inflation to accelerate via the cost structure of business, so when they start hiking, inflation accelerates. Guaranteed!

Only a major supply response will break the inflation. Like pluggable hybrids in 5-10 years or cutting the national speed limit to 30mph, which is highly doubtful.

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There have been a lot of Fed speakers; so, I’ve selected a few comments on Yellen’s speech, as she has been deemed the most dovish Fed bank president.

Note the shift in rhetoric from ‘market functioning’ to inflation.

Of course, the FOMC’s idea of getting tough and fighting inflation has been to only cut 25 basis points.

Data dependent, this seems to be changing.

It could be the signs of passthrough from headline to core CPI or signs inflation expectations are elevating (as per their recent comments).

They also seem to have lost confidence in their inflation forecasts and may not be giving their future inflation indicators the same weight as in the past 6 months.

Fed’s Yellen: Funds rate been cut enough for now

by Ros Krasny

(Reuters) - San Francisco Federal Reserve Bank President Janet Yellen said on Wednesday that the federal funds rate has been lowered far enough for now after months of aggressive central bank rate cuts.

The Fed’s key monetary policy tool ‘has come way down,’ Yellen said while critiquing presentations on the economy at a symposium for college students organized by the San Francisco Fed and the Pacific Northwest Regional Economic Conference.

Yellen said the Fed continues to grapple with difficult policy choices but restated that high inflation was a worry. ‘The 1970s were a horrible period. If there’s one thing that has to be very high priority, we don’t want to go back to a period that is anything like that,’ she said.

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right, it’s a way to keep the ff rate from falling below target, but does nothing for ‘liquidity’ that’s not already being done.

seems fomc maybe still struggling with ‘monetary operations’

From: Adam
Sent: Tuesday, April 29, 2008 3:59 AM
To: a
Subject: CS: DEF WORTH A READ - GREG IP ARTICLE THAT PROPOSES ANOTHER FED INNOVATION - ALL EXPLAINED BELOW

Greg Ip’s piece in the WSJ received some attention today. The piece is titled “ Fed to Consider Paying Interest To Commercial Banks on Reserves” and states that the Fed will discuss this proposal at todays meeting. There is no suggestion that the Fed are about to immediately change the current standard policy of paying zero per-cent for reserve balances, but given that the press had a very good lead on the introduction of the TSLF and PDCF it’s prudent to pay attention. (http://online.wsj.com/article/SB120941973079950909.html?mod=economy_lead_story_lsc)

The reason for changing policy and paying interest on reserve balances is not at first obvious, but is in fact a simple way for the Fed to solve the problem of increasing cash liquidity in the banking system without driving down the Fed effective rate. As the Fed take illiquid asset-backed securities from banks they hand over cash in return. As banks get zero interest on reserve balances that are left with the Fed they quickly seek to place their newly raised cash out into the market, earning a coupon on their investment instead of earning nothing on a reserve balance. As the Fed pay nothing it is in every banks interest to lend any excess balances at rates greater than zero, and what typically happens is that the cash market rate falls dramatically as cash rich banks try and find bids, offering at lower and lower rates until we get close to zero. This is an unwelcome development from the Fed’s perspective as the effective Fed Funds rate that results is often significantly lower than the official Fed target rate. By injecting large amounts of cash liquidity into the system the Fed may actually undermine their own target rate.

Paying a coupon on reserve balances would allow the Fed to inject as much cash via asset-backed repo as they like without needing to worry about driving down the Fed effective cash rate. The Fed would effectively sterilize their own cash injection by placing a guaranteed fixed rate floor on reserve funds, and ensuring that something close to the Fed Funds target rate was achieved. This would mean that the Fed could continue to increase the amount of repo’s that they are willing to undertake and to upsize the auctions without concerns about the effects of huge amounts of excess cash

sloshing around in the system.

Some thoughts to go along with this:

• Great care needs to be taken in setting guaranteed cash levels. Sometimes unexpected consequences result. Central banks like the RBA and RBNZ  have long operated a cash system which guarantees a floor on overnight rates at a margin below the target rate. This ensures that cash generally trades close to the target rate, or slightly rich to it. Generally local market participants prefer to hold an excess of long balances in the knowledge that cash shortages often occur, but they have a defined downside guarantee. In New Zealand’s case the RBNZ found that banks were hoarding cash to such an extent that the short dated market traded significantly above the OCR target because the banks had a 25bp downside guarantee. It wasn’t until the RBNZ reduced the guaranteed floor substantially that rates traded much closer to target.

Banks that get cash from the Fed via the PDCF currently seek to off-load that cash to the street, effectively spreading liquidity to all elements of the banking system, and discouraging the holding of very short term balances which will end of earning 0% if they are not on-lent. If the Fed’s guaranteed rate is not far enough below the FF target rate Banks will simply recycle any excess back to the Fed rather than taking unsecured interbank credit risk. This may leave the smaller regional Banks without direct Fed access short of cash, forcing them to pay a premium instead of getting funds at a discount. T